When a firm goes public in the equity market, it typically engages an investment bank (underwriter) to oversee the valuation, marketing, and legal aspects of the offering. Moreover, in a firm commitment (underwritten) offering the investment bank guarantees the sale of a specified number of shares at a designated offer price, thereby guaranteeing the issuing firm a set level of proceeds.
As such, the risk of sale is transferred from the issuer to the underwriter. In exchange for this guarantee, and as compensation for other services performed, the underwriter charges a gross spread on the offering.
The gross spread is specified as a percentage of the proceeds from the offering. For the majority of standard-sized equity issues, the gross spread is relatively fixed at the 7% level. For the smallest offerings, primarily penny stock issues, the risk is higher, and therefore, spreads tend to be larger.
Most of these issue types face a gross spread of 10%. For larger offerings, economies of scale and reduced pricing risk typically result in lower gross spreads, likely in the 4–5% range.
Gross spreads are not specific to equity issues, but are generally applied in any situation where the investment bank is underwriting a security issue. The other common occurrence, therefore, deals with the public issuance of debt.
In such cases, the gross spread percentage is much smaller (typically around 2%, on average), as there is less pricing risk associated with debt issues relative to equity issues.